Investing For Your Future
Monthly IFYF Investment Message
February 2007
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Do you know how your investments performed last year relative to "benchmark" indicators such as the Standard and Poor's 500 stock index? If not, you are not alone. According to an article, "Did You Beat the Market?," in the January 2000 issue of Money, many investors (as many as 80% of those studied) don't have a clue how their investments performed relative to market indicators. Several studies were cited showing that investors also tend to exaggerate their returns. For example, more than a third of investors who claimed to beat the market actually lagged it by 5% or more.
The author of the article speculated that one reason for investor's overestimation of their return is "human nature." People like to believe that they are "better than average" and brag about how their "superior" investments "beat the market." Another explanation is that many investors don't know how to calculate the return on their individual portfolio or are unaware of the performance of appropriate market benchmarks (e.g., stock market indices) to compare their returns against.
By February of each year, most investors have received statements from their investment account custodians with data about distributions (e.g., interest, dividends and capital gains) and year-end balances. This information is necessary to calculate capital gains taxes or losses that are reported on Schedule D. Account statements can also be used to track investment performance. This Investing For Your Future message describes a "ballpark" formula for determining the performance of one's investment portfolio.
Using the result of this calculation, investors can determine how their investments fared and whether or not they actually "beat the market." Surprisingly, the math needed to do this calculation is very simple. All you need to know is your portfolio balance at the beginning and end of a particular year (e.g., 2006) and the amount invested throughout that year. The amount held in all types of assets (e.g., stock, CDs) can be combined into one calculation to determine the return of an entire portfolio or you can calculate the performance of each investment separately.
For example, in the illustration below, let's assume that an investor started the year out on January 1 with a $15,000 balance in three investment accounts (e.g., a stock index mutual fund, a 401(k) invested primarily in equities, and a bank CD). By December 31 of that same year, the portfolio balance had grown to $20,000. In addition, the investor added $100 a month to both the 401(k) and the mutual fund ($200 total) for a total investment deposit of $2,400 (12 months x $200).
To calculate your portfolio return, take the beginning balance ($15,000) and add to it half of the total annual deposits ($1,200) for a total of $16,200. Then take the ending balance ($20,000) and subtract half of the total annual deposits ($1,200) for a total of $18,800. Finally, divide the adjusted ending balance ($18,800) by the adjusted beginning balance ($16,200), which equals 1.16. Then, to turn the number into a percentage, subtract 1 and multiply by 100 (1.16 -1 x 100 = 16). In this example, the investor's return on the entire portfolio, consisting of the three different assets, was an outstanding 16%.
If, on the other hand, the ending portfolio balance was $17,000, the divisor in the calculation would be $15,800 ($17,000 - $1,200) and the math would look something like this: $15,800/$16,200 = (.9753 - 1 x 100 = -2.5%). While the end of the year account balance was higher than the beginning of the year, this was due primarily to account deposits (plus CD earnings) and not to overall investment performance, which was a negative number.
It's that easy to estimate your investment return. Then you'll know for sure whether or not you actually "beat the market." February is a great time to do this calculation. As you receive end-of-the year tax statements and begin to prepare your taxes, you'll have all the information you need.